The Credit Crunch – what happens now?

The credit crunch has morphed into an ugly global economic downturn, sucking in a scandalous amount of state capital and scaring us all witless in the process.

Trust and confidence in the financial system have taken a real battering. Now that the dust has settled and the causes of this mess are clear, the legacy will be increased regulation, in the banking sector at least, as governments seek to restore lost trust, increase confidence and prevent similar crises in the future.

Indeed, the recently published Turner Report proposes a whole host of new rules. These include rules on capital adequacy, rules requiring greater liquid asset ratios, and rules which focus on regulating banks’ off-balance-sheet liabilities, SIVs, hedge funds and the like. The Turner Report also deals with the role of credit rating agencies, the use ocredit rating agencies, the use of credit default swaps and – perhaps most interestingly from a tabloid perspective given the ongoing furore over bonuses and Sir Fred Goodwin’s pension – the ways in which banks remunerate their employees.

If we are to believe Alistair Darling it will not be long before we will have another report – the Walker Report, presumably – which proposes measures to strengthen banks’ corporate governance.

We can also expect a new regulatory philosophy. Hector Sants, the Chief Executive of the FSA, said when he addressed the Reuters newsmakers Event on 12 March that regulation generally would now be “outcomes-based”. This is not just the new name for principlesbased regulation (like Aviva and Norwich Union, or Starburst and Opal Fruits). It is intended to be a bold new approach under which the FSA will question fifi rms’ business strategies with a view to spotting the ones that risk damaging its statutory objectives, such as market confidence. This new philosophy will be delivered via a more direct and more intrusive form of supervision, for which the FSA has already increased its staff by 30%. Ultimately, however, Mr Sants appeared to accept that there is no perfect means of regulating such a complex industry and that mistakes will inevitably be made in the future.

What we found particularly interesting was Mr Sants’ observation that the financial markets refuse to regulate themselves because, far from being rational systems, they are in fact behavioural systems built around our own personal aspirations. Since people commonly aspire to accumulate wealth and have a tendency to want to ‘beat the market’, there is normally an incentive to speculate and innovate. (This, of course, is one of the things that leads to boom, bust being the market’s crude way of regulating itself.) We suspect that banks and insurers (at least those that are not supported by the state) will continue to develop new products which create systemic risks just so long as there are people out there who want to steal a march on the rest.

It may be that that innovation will take the form of a return to a classic banking model in which investment capital is raised by deposits and other straightforward means – the watchword at the moment is ‘deleveraging’, which in essence is getting rid of one’s debts and credit default risks. Profifi t might be lower under this model, but not greatly, when the lack of risk is factored in.

The real aim is to restore the trust and confidence that has been so badly damaged. Regulation to ensure this never happens again is important, but it is also important for people to know that those responsible can be held accountable.